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Sequencing risk is one of the most talked
about risks to retirement income. That
is, if you get large negative returns
at the wrong time, particularly the 10-year
period before and after retirement, you’ll
be worse off than people who experience
large negative returns at other times – earlier
in their working life or later in retirement.
The most common response to managing
sequencing risk has been to reduce exposure
to growth assets as retirement approaches
– the objective being to reduce volatility
to lessen the impact of market draw-backs.
However, this is a cure that harms as many
as it assists. Reducing risk also reduces
expected returns – if the sequence of returns
is favourable it will make you
worse off.
Asset allocation is a major determinant of
investment returns. The following table provides
a set of long term capital market assumptions for
different levels of exposure to growth assets.
Based on these capital market assumptions,
reducing exposure to growth assets from 70/30
to 50/50 will lower expected returns by 0.5 per
cent per annum. It locks in lower expected returns
leading to lower expected income. Compounded
over a 30-year timeframe this will have a major
impact on the member’s retirement income.
Given this, are there any other approaches that
we can take to managing sequencing risk?
It is well understood in investing that risks are
not additive. That is, a willingness to accept one
type of risk will often reduce your exposure to
other forms of risk. Conversely, a desire to avoid
one type of risk may increase your exposure to
other risks.
For sequencing risks in retirement, this counter-
balancing risk is income risk (volatility in the
amount of annual income received). If you have
zero exposure to income risk (for instance, your
income is a set dollar amount) then you have
greater exposure to sequencing risk. However, if
you have the willingness and capacity to accept
income risk, then your exposure to sequencing
risk and longevity risk (the risk that you will
outlived your savings) are reduced.
Consider a person who commences retirement
with $250,000. By taking their income as a set
dollar amount of $12,500 a year, they have
elected to have zero exposure to income risk.
The following two tables show two scenarios
with the same total return over a five-year period.
In the first scenario the negative returns are at the
end of the period while in the second scenario
the negative returns are at the start of the period.
While in both scenarios the person receives the
same level of income (zero exposure to income
risk), in the second scenario they end up with
a balance almost $40,000 lower than the first
scenario. This lower balance drives their future
income stream leaving them permanently worse
Exposure to growth assets
Expected long-term return
100/0
6.5%
70/30
6.0%
50/50
5.5%
30/70
5.0%
Source: Author’s estimate
Superfunds October 2016